The Growing Threat Posed by the Federal Deficit

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Advisor Perspectives
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Debt

Our fiscal deficit, as measured by the debt-to-GDP ratio, has grown to levels that could impede growth, as predicted by financial theory and confirmed by empirical evidence. Moreover, new research shows that our burgeoning deficit could increase risk premiums for both stocks and bonds.

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Debt

As the chief research officer of Buckingham Wealth Partners, I’ve been getting lots of calls from advisors concerned about the rapid growth in our debt-to-GDP ratio as well as the uncertainty over the future path of fiscal policy (including the underfunding of Social Security, Medicare and Medicaid). The concerns are based on not only the current level of debt, which reached a record $30 trillion in January 2022 (compared to the GDP of about $24 trillion), but also the fact that the ratio of federal debt held by the public to the GDP now stands at about 100%. Note that the total debt, which includes debt held by federal agencies – debt the government owes to itself and thus is netted out – is above 120%. A further concern is that inflation and the resulting rise in interest rates will exacerbate the debt problem. To answer the question of whether advisors and their clients should be concerned, we turn first to economic theory and then review the empirical research.

Why would a large federal debt have negative effects on the economy?

Economists have noted several reasons why high levels of debt-to-GDP can adversely impact medium- and long-run economic growth:

  • High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates and inflation, and by placing future restraints on countercyclical fiscal policies that will be needed to fight the next recession (which may lead to increased volatility and lower growth rates).
  • Large increases in the debt-to-GDP ratio could lead to not only much higher taxes, and thus lower future incomes, but also intergenerational inequity.
  • Increased government borrowing competes for funds in capital markets, crowding out private investment by raising interest rates. Higher rates, along with higher taxes, increase the cost of capital and thus stifle innovation and productivity, reducing economic growth.
  • If the government’s debt trajectory spirals upward persistently, investors may start to question the government’s ability to repay debt and may therefore demand even higher interest rates.
  • Growing interest payments consume an increasing portion of the federal budget, leaving lesser amounts of public investment for research and development, infrastructure and education.
  • During high-debt periods, a large stimulus plan faces resistance from fiscally conservative policymakers and is more difficult to pass. Consequently, fiscal policy fails to provide stimulus in time of need and leads to more risk and higher risk premia.

With that understanding, we turn to a review of the literature on the concerns about the potential for negatively impacting economic growth once debt-to-GDP approaches the level we are now at in the U.S.

The evidence

To evaluate the claim that high government debt-to-GDP ratios had negative effects on the growth rate of an economy, Veronique de Rugy and Jack Salmon reviewed the literature (24 studies) on the relationship between government debt and economic growth in their 2020 paper, “Debt and Growth: A Decade of Studies.” They found that every study except two found a negative relationship between high levels of government debt and economic growth, with a large majority of studies finding a threshold somewhere between 75% and 100% of GDP. They concluded that the empirical evidence overwhelmingly supports the view that a large amount of government debt has a negative impact on economic growth potential, and in many cases that impact gets more pronounced as debt increases.

In 2021 the Cato Institute undertook a review of 40 studies published between 2010 and 2020: “The Impact of Public Debt on Economic Growth.” The authors found that “at low debt levels, increases in the debt ratio provide positive economic stimulus in line with conventional Keynesian multipliers.” However, “once the debt ratio reaches heightened levels (nonlinear threshold), further increases in the debt level as a percentage of GDP have a negative impact on economic growth.” In other words, “a nonlinear threshold could suggest that increased government borrowing competes for funds in the nation’s capital markets, which in turn raises interest rates and crowds out private investment, confirming the debt overhang theory.” Their findings where consistent with those of the 2011 study, “The Real Effects of Debt,” by the Bank for International Settlements. The authors concluded: “At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. … Beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems.” The authors estimated that after the threshold, an increase of 10% in the government debt-to-GDP ratio will lower annual economic growth by 0.17%-0.18% over the following five-year period. The authors of the 2012 study, “Is High Public Debt Always Harmful to Economic Growth?” found the same negative relationship, though their estimate of the threshold was somewhat higher, at 115% (a level the U.S. may reach in the near future).

Read the full article here by , Advisor Perspectives.

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